Retailers often find accounting for merchandise inventory challenging and time-consuming, especially when they carry many different types of products. The retail inventory method simplifies the process by allowing taxpayers to approximate ending inventory without necessarily taking a physical inventory count. In August, the IRS issued final regulations on certain changes within the retail inventory method. Then, the IRS followed up by issuing guidance to explain how taxpayers can obtain automatic approval from the IRS to make certain accounting method changes within the retail inventory method.

What’s the Retail Inventory Method?

For federal tax purposes, a retailer may elect to use the retail inventory method to compute the value of ending inventory at either its approximate retail cost or its approximate lower of cost or market (retail LCM).

To compute the value of ending inventory, the taxpayer simply multiplies the retail selling prices of merchandise available for sale at the end of the tax year by a cost complement ratio. This ratio equals:

(Cost of beginning inventory + Cost of purchases)

(Retail value of beginning inventory + Retail value of purchases)

This method assumes that there’s a predictable relationship between the cost of merchandise and its retail price. Similar products are pooled together in order to estimate an average percentage of cost-to-retail price. The retail inventory method is reliable only if the retailer maintains accurate records of the full cost and retail value of merchandise purchased, merchandise available for sale and the total number of sales for a fiscal period.

For example, suppose a department store’s records show that its cost complement ratio is 75 percent. The retail value of ending value can be computed by adding the retail value of beginning inventory to the retail value of purchases and subtracting sales. The retail value of ending inventory is converted to its approximate retail cost using the store’s cost complement ratio.

Even if a retailer conducts a physical inventory count at year-end, the retail inventory method can facilitate the process, because the store needs to record only the retail prices of merchandise.

What’s Changed?

In August, the IRS released final regulations on the retail inventory method that clarify a taxpayer’s treatment of certain sales-based vendor allowances, margin protection payments, permanent markups and markdowns, and temporary markups and markdowns when determining the cost complement ratio. The changes apply to tax years beginning after December 31, 2014.

Specifically, when calculating the cost complement ratio, the denominator should be the retail selling prices of beginning inventory plus the retail selling prices of goods purchased during the year, adjusted for all permanent markups and markdowns, including markup and markdown cancellations and corrections. The denominator is not adjusted for temporary markups or markdowns. The numerator of the cost complement ratio also should not be reduced by vendor allowances required to reduce only cost of goods sold.

Taxpayers that use the retail LCM method generally may not reduce the numerator of the cost complement ratio by margin protection payments that are intended to compensate for a reduction in the taxpayer’s retail selling price of inventory.

An alternative method for taxpayers that use the retail LCM is to reduce the numerator of the cost complement ratio by the amount of margin protection payments if the taxpayer also reduces the denominator of the cost complement ratio by the amount of the reductions in retail selling price to which the margin protection payments relate (related markdowns).

If the taxpayer cannot determine the amount of the related markdowns, it may reduce the numerator of the cost complement ratio by the amount of margin protection payments and adjust the denominator by the amount that, in conjunction with the reduction of the numerator, maintains what would have been the cost complement ratio before taking into account the margin protection payments and related markdowns.

Obtaining Automatic IRS Approval for Changes Within the Retail Inventory Method

IRS rules require taxpayer to obtain the IRS’s consent before changing a method of accounting for federal tax purposes. IRS Revenue Procedure 2014-48 details the procedures by which a taxpayer obtains IRS’s automatic approval to make certain accounting method changes within the retail inventory method.

Retailers can make the change in their first or second tax year beginning after December 31, 2014, and can either use an Internal Revenue Code Section 481(a) adjustment or make the change on a cutoff basis. Section 481(a) requires certain adjustments necessary to prevent amounts from being duplicated or omitted when a taxpayer’s taxable income is determined under a method of accounting different from the method used to determine taxable income for the preceding tax year.

If a cutoff basis is used, the change applies only to the computation of ending inventories after the beginning of the year of change. If multiple changes are desired for the same tax year, they should be made on a single Form 3115.

Retailers that want more information on the retail inventory method or the latest IRS updates should contact a tax professional before year end.